Magazine

It Feels Like 1998 All Over Again

May 21, 2006

When Caterina Fake, co-founder of the Flickr photo-sharing Web site, sat down in March to write a blog entry, she expected to rankle some readers. Her post, titled "It's a bad time to start a company," was a frank argument that a bubble was reinflating Internet businesses. Valuations are rising, hordes of copycat companies are getting funded, and venture capitalists are flooding hot areas with money again. Fake, who bootstrapped her company on $250,000 after the dot-com bust and sold it last year to Yahoo! Inc. (YHOO), wrote that those trends are making it impossible for upstarts to stand out. She dissed the notion that a second wave of Net development, dubbed Web 2.0, will benefit all the new ventures, many of which she called "features," not companies. The frothiness, she added, reminded her of 1998.

No sooner had Fake pushed the publish button than comments started pouring in. Most said she was dead wrong. "I must totally disagree with you," wrote the first respondent, arguing that the time is right to strike out on one's own. "Now that money is flowing again, working for yourself is the only way to really cash out." That reaction left Fake more convinced than ever. "It basically proves my point," she says. "I see so much me-too that's happening now -- people who are saying: 'We're going to add tagging, social networking, and sharing, and voilà, we will get rich."'

SEE NO EVIL

Are we or are we not in an Internet bubble? The debate flares up at industry parties, conferences, and in blog discussions like a never-ending marital spat, dragging in even those who are tired of the question. John Doerr, partner at venture capital firm Kleiner Perkins Caufield & Byers, won't even use the word bubble, preferring to call the late '90s "the boom." Others find the whole discussion counterproductive. "There are lots of people saying: 'Gee, we're busy trying to build real businesses here, and people are wasting our time talking about whether this is a bubble,"' says David Hornik, partner at VC firm August Capital.

But comparisons with the roaring '90s are inescapable. San Francisco's South of Market, or SOMA, district, a barren wasteland after the dot-com bust, is once again bustling with startups, bars, and restaurants. In April the district was beset by a record 9,000 attendees of the annual ad:tech conference. The three-day Internet industry get-together featured company-sponsored parties that recalled the Great Bubble's hedonistic days, even including a Girls Gone Wild party.

Amid the resurgence, startups are again throwing attention-grabbing parties to rise above the din, albeit with moderation born of hindsight. "I call it rational exuberance," says David Thompson, CEO and co-founder of Genius Inc., a San Mateo (Calif.) Web analytics software startup. Genius rented out the San Francisco Museum of Modern Art on May 3 for its coming-out fete. Employees donned bright orange shirts, bartenders poured orange Genius cocktails, and television cameras captured the 400 guests for a local news broadcast. Conspicuously absent were such '90s touches as $10,000 ice sculptures. Instead, Thompson handed out acrylic award statuettes to favorite clients, subtly reminding guests that, unlike dot-coms of yesterday, the company's debut comes with a finished product and paying customers.

Concerns about a second bubble aren't baseless. Clearly, valuations of startups are rising. In the fourth quarter, 75% of startups with VC funding were valued higher than when they last raised cash -- up from 60% a year earlier, according to Palo Alto (Calif.) law firm Cooley Godward. And acquirers have paid eye-popping prices for a few startups: eBay Inc. (EBAY) shelled out more than $2.6 billion for Skype Technologies (EBAY), and News Corp. (NWS) forked over $650 million for MySpace.com (NWS). In the last quarter, VC firms plowed $5.6 billion into 761 companies, up 12% from last year, says MoneyTree Report.

TOO EARLY

The cult of startups is reemerging, too, with breathless speculation surfacing in the mainstream media or on hot blogs long before the companies launch. "It doesn't help to get attention at such an early point," says Jakob Lodwick, 24, a partner in CollegeHumor.com, a popular video site that soldiered through the downturn. "It's kind of like if you have a gifted kid and tell the parents he'll be a genius and make a lot of money when he grows up, the parents might change the behavior that made him a genius."

The Net revival even has a catchy name. Although no one agrees on the precise meaning of Web 2.0, its ideology holds that a second generation of Internet companies will improve on the groundwork laid by the first generation. Like the New Economy and other theories that accompanied past bubbles, Web 2.0 maintains that we have entered a new era in which the rules are different: Net startups no longer require lots of capital, they can build cheaply on Net infrastructure that didn't exist 10 years ago, and a critical mass of consumers is now online.

Still, the craziness is far from the level that preceded the Net bust. Credit a picky market for initial public offerings and reasonable prices for most publicly traded tech stocks. Last year, 56 VC-backed companies raised $4.5 billion through IPOs, nowhere near the 223 companies that raised $17.8 billion in 1999. And the NASDAQ Composite Index on May 5 was down 54% from its peak of 5,048 on Mar. 10, 2000.

Ultimately, the question of whether another Internet bubble is forming may be unanswerable. Still, the debate is key to understanding the industry's mindset. The Great Bubble of the late '90s shaped a generation of Internet entrepreneurs and investors much as the Great Depression shaped a generation of economizers in the mid-20th century. "The bubble generation is much more attuned to the fact that things can get really out of hand," says Bill Burnham, a former partner at Mobius Venture Capital. "There's a level of caution that has been ingrained."

That's why entrepreneurs have developed an ultra-practical approach to creating companies. In the '90s, founders raised tens of millions of VC dollars with plans to expand until a company could go public at a ten-figure valuation. Today, thanks to open-source software, falling hardware costs, and outsourcing, companies can be created on less than $1 million and sold fast. Case in point: News Corp. (NWS) on May 1 bought NewRoo Inc. (NWS), a year-old news aggregator that had not raised venture capital or even launched its service.

JUST A LITTLE TWIST

But the rising prices of Net startups are fueling a surge of me-too companies in hot areas such as social networking. With little investment required, these products are easily imitated. "We're in a company-creation bubble," says Joe Kraus, co-founder of Web publisher JotSpot Inc. "A lot of these companies will die."

Over the past decade entrepreneurs and investors have developed a peculiar tunnel vision about what works and what doesn't. That can hinder creativity. Financiers and founders may say they're looking for new Net ideas when, in truth, they're not. "They want only an idea that has been shown to work in the past with just enough twist to make it a new idea," says Edward de Bono, an expert on creative thinking.

So if cheap, identical startups are multiplying daily, is the Internet industry necessarily headed for another colossal crash? Hardly. The Great Bubble may have destroyed fortunes and jobs when it burst. But the history of Silicon Valley is replete with many small bubbles that served to motivate entrepreneurs and investors without causing widespread harm. The lure of instant wealth drove the development of industries from disk-drive manufacturing to computer gaming. "Silicon Valley needs champagne bubbles all the time to be percolating up for the whole system to work," says James F. Fulton Jr., an attorney at Cooley Godward. But a few more $1 billion-plus deals could shake up the bottle.